Pablo
Ltd. (PL) reproduces fine works of art as posters. The company was started 10
years ago with used equipment. Demand for the posters increased recently when
PL began to glue the posters onto a wood backing and laminate them. The old
equipment has become very expensive to maintain and keeps breaking down,
disrupting production. Pietro Pablo, the owner, has decided to go to the bank
for a loan to buy new equipment. In preliminary talks with the bank, the
manager indicated that financial statements are needed from PL for the year
ended December 31, 2011.
While
the statements have now been drafted, Pietro is not happy with the net income
figure, which is lower than he had expected. Pietro calls you, his accounting
manager, and asks if the net income has been correctly calculated. He points to
the large payroll expense, which has increased over the last year. You note
that the main cause of the increase is that pension expense increased for the
following two reasons:
1.
The employee pension plan was renegotiated at the beginning of the year and a
key change was to increase the amount of pension benefits for each employee for
each hour worked. The plan is a defined benefit plan and the amendment provided
for retroactive application, so that most of the employees, who were older,
would benefit from the plan. The increase in the pension obligation arising
from this amendment is being amortized to net income over 14 years, beginning
with 2011.
2.
The actuary has recently prepared a new actuarial valuation of the pension
obligation. In doing so, she suggested that the interest rate used for
discounting be changed to reflect recent reductions in interest rates.
Short-term interest rates have declined but many economists predict that the
mid- to long-term rates will remain more stable at the higher rate. The
reduction in the interest rate for discounting has resulted in an increase in
the pension obligation. The increase is also being amortized to net income over
14 years, beginning in 2011.
Pietro
asks you to determine whether there is any flexibility in applying PE GAAP. The
company is a private company.
Instructions
Discuss
the financial reporting issues.
Overview
-
It would appear that the financial statements
are being prepared for the bank for purposes of obtaining a loan or financing.
The bank will want conservatively prepared statements with full disclosures so
that they can make their decision.
-
Pietro, on the other hand, is biased in that he
wants the financial statements to look as good as possible to induce the bank
to give him the financing.
-
GAAP would appear to be a constraint since the
bank will want reliable information. Pietro is interested in whether there is
flexibility in applying ASPE. Note that the company could also follow IFRS.
-
Care should be taken since it appears as though
Pietro is trying to bias the numbers. Accounting should be neutral. In your
role – ensure that the accounting used results in the most transparent
financial statements.
Analysis and Recommendations
The main issues are how to account for the
amendment to the plan and whether the increase in the obligation due to the
change in assumptions is valid and has been accounted for properly.
Issue: Amendment to the plan:
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ASPE
|
IFRS
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- ASPE
allows the entity to use the immediate recognition method or the deferral
and amortization method.
- Under
the deferral and amortization method, there are additional choices.
- May
choose to recognize all of the change in current income or defer.
- If
deferred – amortize over the period deemed to benefit from the amendment
(generally expected eligibility period although may be shorter).
- Note
that full recognition will worsen net income this year but net income will be
higher next year.
- If
deferred, should recalculate the 14 year period to eligibility to ensure
appropriate.
- Under
the immediate recognition method - the company may choose to fully
recognize any changes in the surplus/deficit of the plan (immediate
recognition method). Must use a funding valuation measure (actuary may be
more conservative in the assumptions).
|
- Generally
- defer and amortization approach although the option exists to recognize
most changes directly in income or comprehensive income.
- If
the past service costs are vested, then must recognize immediately in net income.
Otherwise amortize over the average period until vesting occurs.
- In
all likelihood, the benefits are vested and so the company would have to
recognize the costs in net income in the current year.
|
Recommendation: There are many choices as to
how to present the information. The company also has the choice to follow IFRS
as well. Note that no matter what the accounting is, the economic reality is
the same (i.e. same pension plan). Care should be taken to ensure that the bank
understands this and that the cash flows will be the same no matter which
accounting policies are followed.
Issue: Changes in the assumptions - the change
in the assumption regarding the discount rate has caused the pension obligation
to increase.
|
ASPE
|
IFRS
|
|
- May
use either a current yield on high-quality debt instruments or a current
settlement rate. The cash flows should match that of the
benefit obligation.
- The
choice of interest rate in this case appears to reflect short-term interest
rates. This is not necessarily appropriate since the pension plan obligation
is of a long-term nature. Market interest rates should be used that
reflect/match timing and amounts of benefit payments. This means that the
long-term nature of the plan should be considered.
- Under
the deferral and amortization method, the entity must recognize a
minimum amount of amortization if the opening unrecognized balance exceeds
the greater of 10% of the ABO and FV of assets. The minimum amount equals the excess noted
above divided by the expected average remaining working lives of employees.
- Under
the deferral and amortization method, the company may also choose to
fully recognize any changes in net income immediately.
- Under
the immediate recognition method - the company may choose to fully recognize
any changes in the surplus/deficit of the plan. Must use a funding valuation
measure (actuary may be more conservative in the assumptions).
|
- Under
IFRS must use the current yield on high-quality debt instruments. The
currency and term of the instruments should be the same as the benefit
obligation.
- The
current choice of interest rate in this case appears to reflect short-term
interest rates. This is not necessarily appropriate since the pension plan
obligation is of a long-term nature. Market interest rates should be used
that reflect/match timing and amounts of benefit payments. This means that
the long-term nature of the plan should be considered.
- Any
changes may be recognized immediately income or other comprehensive income.
Alternatively, the entity must recognize a minimum amount of amortization if
the opening unrecognized balance exceeds the greater of 10% of the DBO and FV
of assets. The minimum amount equals
the excess noted above divided by the expected average remaining working
lives of employees.
|
Recommendation: There are many choices as to
how to present the information. The company also has the choice to follow IFRS
as well. Note that no matter what the accounting is, the economic reality is
the same (i.e. same pension plan). Care should be taken to ensure that the bank
understands this and that the cash flows will be the same no matter which
accounting policies are followed.
